Do you remember the scene from Willy Wonka and the Chocolate Factory where you see people desperately trying to buy the winning Wonka chocolate bar? The film, though more renowned for its other aspects, conveyed to me in the most simple terms, an old yet inchoate idea of auctions and created a lifelong fascination with this unique economic market. If the bids at two of the biggest auction houses, Sotheby’s or Christie’s drive you crazy, welcome to the club!
What makes an auction a quintessential economic market is its structure and its quest for allocative efficiency. To add to this, the issue of withholding of information from both, the buyers and the sellers end – what economists call adverse selection – might be essential for the valuation of the resource. All these ingredients make auctions a textbook example of economic markets and their mechanism. Thus, an auction becomes an economic game, where there is a specific set of rules detailing the procedure of resource allocation. It is further characterized by a lack of complete knowledge with respect to the resource under consideration.
Applications of auctions are not only limited to the Sotheby’s and Christie’s premises but have also expanded to include search engine advertising. However, before we delve into the wide array of its application, it is important to demystify the various types of auctions and their usage. Since the reasons why we auction goods differ and the goods that we are bidding on are usually scarce or one-of-a-kind, it becomes important for us to intervene with an appropriate economic design to ensure effective allocation of the resource. To make it easier, William Vickrey introduced the auction taxonomy in the vocabulary of economics:
(1) English Auctions (the ascending-bid auction)
(2) Dutch Auctions (the descending-bid auction)
(3) The first price sealed bid auction (blind auction)
(4) The second price sealed bid auction (Vickrey auction).
Let us deconstruct these types of auctions to better understand their workings.
If you have ever taken part in an eBay auction, you know what an English auction is. These are the kinds of auctions that come to mind when we think of one – an open outcry ascending auction. In such an auction, there is a minimum price, to begin with (starting price/reserve price) and people keep bidding for a specified time frame. The one with the highest bid wins. This type of auction is advantageous to buyers as there is a chance of the winning price being less than their valuation of the resource. At the same time, sellers love this type of auction because people tend to get carried away with increasing bids and tend to bid higher than the value they place on the resource under contention, a situation economists term the winner’s curse. It is a phenomenon in which all bidders receive the same value from the resource but all of them have different ideas and signals about the resource. Suppose you have to bid for oil rights. As you do not have complete information, you have to make a rough estimate of the value of the oil field. If you presume a larger value of the oil field, you will end up bidding high in order to ensure you win and, hence, will fall prey to the winner’s curse. The sum and substance are that the winning curse occurs when winning the auction is not the most optimal strategy. Additionally, the actual winners are the ones who play to not win.
The next type is descending bid auction also known as Dutch auctions which are the exact opposite of English auctions. Here, the auctioneer begins with a high asking-price and keeps lowering the price till some participant accepts it or till they reach a fixed reserve price. In 2004, Google adopted the Dutch auction process for it’s Initial Public Offering (IPO) to minimize unreasonable speculation and stock price volatility. This type of an auction is useful as it helps prevent what stock market experts call a pop. A Pop is an increase in the share price on the first trading day; and what seemed to be Google’s aim while adopting this approach.
There is another set of categorizations that depends upon what the winner has to pay. It includes the First Price Sealed Bid Auctions (FPSBA) and the Second Price Sealed Bid Auction (SPSBA). The former is a type of auction where bidders simultaneously bid with no knowledge of other bids. Hence, it is also known as a blind auction. The person with the highest bid wins. On the other hand, in SPSBA (also known as Vickrey Auctions, named after its eponymous theorist William Vickrey), the pattern of accepting the bids remains the same, with the highest bidder winning the resource. However, the price paid is the second-highest bid. This gives the bidders an incentive to reveal their true valuation and reduces the chances of bid shading (bidding less than their true valuation).
Moving on to applications of the auction theory, we find it everywhere; right from sale of art collectibles to real estate auctions. One such interesting application is in the field of search engine advertising. Initially, the advertisers would pay at a rate of per thousand impressions, which was completely revolutionized by the advent of “pay per click” auction in which the advertisers paid a price commensurate with the number of times its ad was clicked on to access its webpage. Higher slots generated a higher number of clicks and only those who bid high got those slots. This made it a classic example of a first priced auction. This, however, posed a problem. Every advertiser wanted to pay the least amount possible. Consider 3 bidders, A, B and, C bidding for an ad slot. They get different utilities or values from the ad slot. With every click, A gets a value of Rs. 10, B gets a value of Rs. 5, and C gets a value of Rs. 3. With competing bids being placed simultaneously, all the advertisers know that A will definitely bid more than B and C (A has a lot more to gain) & B will bid more than C. Assuming bids are rounded-off to the next paisa, B will bid Rs. 3.01 because B knows C won’t bid higher than Rs. 3 and A will bid Rs. 3.02 to trump the bids of both B and C. Thus, the search engine used to lose out on a lot of revenue. The concept of Vickrey auctions provided a whole new twist to the tale. Now, the bidders had to pay the bid amount just below it. This helped to stabilize the search engine advertising market.
Search engines also started to use position auctions. These auctions focus on who wins the auction and what they have to pay. The framework is fairly simple. An advertiser chooses a set of keywords and submits a bid for each of them. When a user searches for any of these keywords, the highest bidder receives the best position (the one that is likely to garner the most clicks) and is charged an amount that depends on what the next bidder (as per the rankings) has bid.
A study of auctions has revolutionized the very basis of how transactions are conducted in an economic setting. It tells us what setting is useful under which conditions to maximize the utility and to achieve the objective under consideration. Auctions are ubiquitous and we play the auction game quite often.
Now armed with the knowledge of auction theory, one can only hope to not fall prey to the winner’s curse! Until then, signing off in search of a new economic adventure!